Income Tax Fundamentals 2010 edition
Gerald E. Whittenburg
Martha Altus-Buller
2010 Cengage Learning
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Gross income is “All income from whatever
source derived”
All sources of income are included unless
specifically excluded (see Table 2)
◦ Non-cash items included at fair market value
Note: Income from illegal activities is includable
in gross income
2009 Cengage Learning
Example
Keeley’s income items for 2009 are:
Wages
$45,000
Bonus (noncash)
8,000
Bond interest
1,200
Dividends
850
Limited partnership loss
(9,000)
Rental real estate income
6,500
What is Keeley’s income by category and total gross income?
2009 Cengage Learning
Example
Keeley’s income items for 2009 are:
Wages
$45,000
Bonus
8,000
Bond interest
1,200
Dividends
850
Limited partnership loss
(9,000)
Rental real estate income
6,500
What is Keeley’s income by category and in total?
Solution
Her active income =
$53,000
(45,000 + 8,000)
Her portfolio income = $ 2,050
(1,200 + 850)
Her passive loss =
($ 2,500)
((9,000) + 6,500)
Her total gross income = $55,050
Note: the passive loss cannot offset active or portfolio income
2009 Cengage Learning
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If total interest income >$1,500 must report
on Schedule B (1040) or Schedule 1
(1040A)
◦ Fair market value of gifts/services a taxpayer
receives for making long-term deposits or
opening an account are taxable interest
2009 Cengage Learning
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Series EE bonds
◦ Purchase at discount and then redeem
 Interest taxed each year as value increases
 Interest taxed in year of maturity or year bonds are cashed in
(whichever is earlier)
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Series HH bonds
◦ Issued at face value
 Pay interest semiannually and it’s taxed each year or at maturity
 Treasury stopped issuing 8/04
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Series I bonds
◦ Purchase for face value
 Earnings are adjusted semiannually for inflation
 Interest taxed each year or at maturity
2009 Cengage Learning
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3 kinds of dividends
◦ Ordinary dividends
 Most common
 Return of net income to shareholders
 Schedule B (1040) when total dividend income > $1,500
◦ Nontaxable distributions
 Return of original investment - not paid from corporation’s earnings
and profits
 Not included in taxpayer’s income
 Reduces basis in stock
◦ Capital gain distributions (CGD)
 When stock reaches zero basis, further distributions are CGD
 Report on page 1 of 1040 or Schedule D
2009 Cengage Learning
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2003 and 2006 Tax Acts resulted in lower tax rates for
qualifying dividends
◦ Defined: “Qualifying dividends” are those that are received
by an individual who has held stock for more than 60 days
during the 120-day period beginning 60 days before stock’s
ex-dividend date
Regular tax
bracket
Qualifying
Dividend Rate
2008-2010
10%, 15%
0%
Higher brackets
15%
◦ If not qualifying, dividends taxed at ordinary rates
2009 Cengage Learning
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Alimony is deductible to payer and taxable to
payee
Alimony payments must meet five
requirements as follows (if subject to divorce
agreement after 1984)
Must be in cash and received by ex-spouse
Must be made in connection with written instrument
Can’t continue after death of ex-spouse
Can’t be designated as anything other than alimony
Parties may not be members of the same
household
2009 Cengage Learning
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Recapture provisions prevent front-end
loading of alimony payments
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Property transfer is not alimony because it’s
not cash
◦ Transferor doesn’t have to recognize any gain on
transaction
◦ Transferee’s basis is same as transferor’s
2009 Cengage Learning
Example
Complying with a 2009 written divorce decree,
Frederik pays Shanna $1,800/month. The
decree specifies that the payments will be
reduced 40% when their daughter, in Shanna’s
custody, becomes eighteen. How much can
Frederik deduct per year as alimony?
2009 Cengage Learning
Example
Complying with a 2009 written divorce decree, Frederik
pays Shanna $1,800/month. The decree specifies that
the payments will be reduced 40% when their daughter,
in Shanna’s custody, becomes eighteen. How much
can Frederik deduct per year as alimony?
Solution
40% of each payment is considered nondeductible child
support; therefore $1,800 x 12 months x 60% =
$12,960/year deductible alimony.
2009 Cengage Learning
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Child support is not deductible to payer and
not taxable to payee
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If payer falls behind on child support, must
bring this current before any portion of
payments considered alimony
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Rules differ for divorce agreements executed
pre- and post-1985
2009 Cengage Learning
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Taxable amount equal to cash prize or fair
market value of property
◦ Exception: Employee awards of tangible personal
property (up to $400)received for recognition of
length of service or safety achievement are
excludable (or up to $1,600 if from award under a
“qualified plan award”)
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Game show and reality TV show winners
should be aware that prizes/awards are
taxable
2009 Cengage Learning
Example
Josef, an employee of Vesuvius Wind LLC,
receives a clock for 20 years of service valued at
$1,500 and the award is not considered a
“qualified plan award”; how much is excludable
from Josef’s gross income?
2009 Cengage Learning
Example
Josef, an employee of Vesuvius Wind LLC, receives
a clock for 20 years of service valued at $1,500
and the award is not considered a “qualified plan
award”; how much is excludable from Josef’s
gross income?
Solution
$400 is excluded and $1,100 would have to be
included in Josef’s gross income calculation
2009 Cengage Learning
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An annuity is an instrument that a taxpayer
buys (usually at retirement) in return for periodic
payments for the remainder of his/her life
The taxable portion of these periodic payments
is calculated based on
◦ mortality tables provided by IRS
and
◦ the annuity purchase price
2009 Cengage Learning
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General Rule
◦ Payments received are both taxable (income) and
nontaxable (return of capital)
◦ Must calculate amount to exclude from income
1. First calculate exclusion ratio:
Investment in Contract / (Annual payment x Life expectancy)
2. Exclusion amount =
Exclusion Ratio x Amount of Annuity Received
2009 Cengage Learning
Example
Din has saved $750,000 in his retirement
account and uses it to purchase an annuity. His
annuity equals $4,800/month and the IRS
tables show he is expected to live 19 years.
How much is excludable each year of
retirement? Assume that Din is required to use
the general rule.
2009 Cengage Learning
Example
Din has saved $750,000 in his retirement account and uses
it to purchase an annuity. His annuity pays $4,800/month
and the IRS tables show he is expected to live 19 years.
How much is excludable each year of retirement?
Assume that Din is required to use the general rule.
Solution
$750,000/($4,800 x 12 months x 19 years) = .685
exclusion ratio
.685 = 68.5% of amount is excluded from tax
.685 x ($4,800 x 12 months) = $39,456 annual exclusion
2009 Cengage Learning
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Simplified Method
◦ Individuals generally required to use this
method to calculate taxable amount from an
annuity - if annuity payments commenced after
11/18/96
 Taxpayer must fill in worksheet provided by IRS.
(See pp. 2-12 and 2-13 for example of simplified
method worksheet)
2009 Cengage Learning
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Employers may make periodic payments to
retirement plans on behalf of their employees
Not taxable to employee in current year
Not considered part of investment when
calculating exclusion ratio
2009 Cengage Learning
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Life insurance proceeds are excluded from
gross income
◦ If proceeds paid to beneficiary by reason of death
of the insured
and
◦ Beneficiary has an insurable interest
Note: Interest on proceeds paid over several years is generally
taxable income
2009 Cengage Learning
Example
Karina dies on 6/15/09, leaving her husband, Dann,
a $500,000 life insurance policy. The proceeds will
be paid to Dann $100,000 per year plus interest for
5 years.
In the current year, Dann receives $105,000
($100,000 + $5,000 interest). How much is taxable
to Dann in the current year?
2009 Cengage Learning
Example
Karina dies on 6/15/09, leaving her husband, Dann, a
$500,000 life insurance policy. The proceeds will be
paid to Dann $100,000 per year plus interest for 5
years. In the current year, Dann receives $105,000
($100,000 + $5,000 interest). How much is taxable
to Dann in the current year?
Solution
Dann must include the $5,000 of interest income in his
gross income calculation; the face value of $100,000
is not taxable.
2009 Cengage Learning
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Also known as accelerated death benefits
Viatical settlements are excludable from gross
income in certain situations as follows:
◦ Chronically or terminally ill taxpayer collects early payout
from insurance company or sells/assigns policy to a viatical
settlement provider
 Terminally ill patient must have certification from MD stating
that he/she reasonably expected to die within 24 months
 Chronically ill must have certification from MD stating the
he/she is unable to perform daily living activities unassisted
2009 Cengage Learning
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If policy is transferred for value, then all or part of the
proceeds may be taxable to recipient
Taxable amount = Proceeds from death of insured
- Cash surrender value (at time of transfer)
- Premiums paid by purchaser to keep policy active
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Exception - If policy is transferred for value to partner of
insured, a partnership in which insured is a partner or a
corporation in which insured is an officer, then policy
proceeds are not taxable
2009 Cengage Learning
Example
Bianca transfers a life insurance policy with a face value
of $25,000 and cash surrender value of $4,000 to
Yvette as payment for services rendered. Yvette pays
premiums of $500 per year for a total of $1,500 in the
ensuing 3 years; Bianca dies and Yvette collects the
$25,000. How much must Yvette include in her gross
income?
How would this answer differ if Yvette and Bianca were
partners in a partnership?
2009 Cengage Learning
Example
Bianca transfers a life insurance policy with a face value of $25,000 and
cash surrender value of $4,000 to Yvette as payment for services
rendered. Yvette pays premiums of $500 per year for a total of
$1,500 in the ensuing 3 years; Bianca dies and Yvette collects the
$25,000. How much must Yvette include in her gross income? How
would this answer differ if Yvette and Bianca were partners in a
partnership?
Solution
Yvette must include $22,500 in income [$25,000 – 4,000 - 1,500]. If
Yvette and Bianca were partners in a partnership, the entire proceeds
($19,500) would be tax-free.
2009 Cengage Learning
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Inheritances are excluded from income
◦ Income generated from property received after transfer is
taxable
◦ Estate may incur taxes
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Gifts received are excluded from income
◦ A gift is defined by the courts as a voluntary transfer of
property without adequate consideration
◦ Gifts in business settings usually considered taxable
income
◦ If recipient renders services for the gift, amount is taxable
2009 Cengage Learning
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Scholarships received for fees, books,
tuition, course-required supplies or
equipment are excluded from income
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Must include scholarship amounts in
income for:
◦ Any amounts applied to room and board
◦ Any amounts received are compensation for
required work
2009 Cengage Learning
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Taxpayers may exclude from income the total
amount received for
◦ Payment of medical care
◦ Payment for loss of a body member or function
(called accidental death and dismemberment)
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Premiums paid by employer on employee’s
behalf are excluded from income
◦ For medical insurance
◦ For Accidental death and dismemberment (AD&D)
insurance
2009 Cengage Learning
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Meals and lodging provided by employer are
generally excluded from income (if following
tests are met)
(1) meals provided by employer on premises during
working hours solely for the benefit of the employer
because employee must be available for emergency
calls or is limited to short meal periods
(2) lodging provided by employer on premises and
must be accepted as a requirement for employment
2009 Cengage Learning
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Taxpayer may exclude interest on state and
local government obligations (called “muni
bonds”) from federal taxation
After-tax return for tax-free bond calculated
as follows:
After-tax return = Tax-free interest rate / (1.00 – taxpayer’s tax rate)
2009 Cengage Learning
Example
Gopal is in the 33% federal income tax
bracket and invests in a Nashville City
Bond paying 6%. What taxable interest
rate will yield the same after-tax return?
2009 Cengage Learning
Example
Gopal is in the 33% federal income tax bracket
and invests in a Nashville City Bond paying 6%.
What taxable interest rate will yield the same
after-tax return?
Solution
Taxable interest rate equivalent = 8.96%
(.06) / (1.00 - .33) = .0896
2009 Cengage Learning
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Part of Social Security benefits may be included in
gross income
◦ Maximum inclusion amount = 85%
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Inclusion based on taxpayer’s Modified AGI (MAGI)
◦ MAGI = AGI + tax-exempt interest (and other items)
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If (MAGI + (50%)(SS benefits)) < base amount* then
benefits are not includable
*If this number exceeds base amount, must compute taxable
portion, see p. 2-19 for worksheet on how to calculate
includable amount
2009 Cengage Learning
If (MAGI + (50%)(SS benefits)) exceeds base amount as
follows:
Base Amount
Filing Status
$32,000
MFJ
$
MFS
0
$25,000
All others
…then, the taxable amount is calculated by completing
the Simplified Taxable Social Security Worksheet
2009 Cengage Learning
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Unemployment compensation payments
are fully taxable in excess of $2,400
◦ First $2,400 nontaxable as part of economic
stimulus act passed in early 2009
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These payments are deductible on some
state’s income tax returns
2009 Cengage Learning
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Employer-sponsored plan allowing employees
to set aside pretax dollars for:
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Dependent care (up to $5,000/year)
Medical/dental/optical care
Health insurance co-pays and some OTC drugs
Public transport/parking up to certain limits
Can result in significant tax savings for
employee
“Use-it-or-lose-it” provision
◦ If amounts are left in plan after certain date, employee
loses them
2009 Cengage Learning
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May exclude certain fringe benefits from gross
income, such as:
◦ ER- paid premiums for group term life insurance up to $50,000
◦ Qualified Employee Discounts with exceptions
◦ Working Condition Fringe
 If you could deduct item on your own as an employee, for example a
subscription to professional journal, it is excludable
◦ De Minimis Fringe Benefits
 These are immaterial and not worth tracking
◦ Tuition reduction
 Different rules for undergraduate vs. graduate
◦ Value of membership to athletic facilities
◦ Retirement planning services
◦ Other excludable fringes
2009 Cengage Learning
2009 Cengage Learning